LIVING THE PROPERTY DREAM – THE WISE PERSON LEARNS FROM THE MISTAKES OF OTHERS

Other than the fortunate few, everyone who aspires to property ownership will need to borrow money in order to live the dream. When the time comes to enter the market, a key challenge will be to ensure that you don’t borrow so much as to cause financial stress and difficulty should your personal or national economic circumstances change for the worse.

In that regard, it’s worth reminding ourselves about the decades leading up to the Global Financial Crisis (GFC) of 2008. In those days, the world seemed awash with greed.  There were ridiculously high levels of personal and corporate debt, justified by enthusiastic rhetoric that the speculative profits and capital gains would never end. Stories abounded of ordinary Australians who had borrowed heavily to purchase the property of their dreams (or in many cases, beyond their wildest dreams). It was not uncommon to hear stories about young couples who owned 10 to 15 highly geared properties where their ownership equity in the total portfolio was 5% or less.

These eternally optimistic people with nerves of steel and sincere (if not naive) convictions about their financial position, owed millions of dollars, were paying a small fortune in mortgage insurance (required to protect the lenders) and were receiving rental income that was nowhere near the monthly payments that they were making on interest only loans from lenders at rates of at least 7.5% per annum, sometimes considerably more.

Being fixed interest loans, the borrowers were comforted to know that their interest payments wouldn’t change during the terms of their loans (3-5 years). However, they also knew, unlike variable interest rate loans, that the principal of their loans (the original amounts borrowed) were not reducing….hence the unrealistic imperative for never-ending capital gains.

Negative gearing

As a result of their high levels of borrowings, these investors were claiming an annual tax deduction for real and substantial annual losses, being the difference between the incoming rents and the outgoing interest, council rates, repairs, insurance, depreciation and other expenses. This practice is known as “negative gearing”. It’s a tax-subsidised arrangement that has been a mainstay of Australian property investors and promoters for decades.

The investors hope, based on historical data and their love of property investing, that the properties on which they have borrowed will increase in value (after capital gains tax) to such an extent as to make their losses irrelevant and the investment risks worthwhile. History shows that many people have done well using negative gearing. Many have not.

Typically, the investors described in this article were convinced that they were on to a winner. They expressed no concerns about the serious risks that most people would perceive in such a highly geared structure, so convinced were they about the future of Australian property which they believed would rise in value forever, thereby creating the financial independence and early retirement that they were seeking.

The Global Financial Crisis (GFC)

Then came the GFC in 2008 accompanied by a frightening economic downturn. A 1929-style depression was predicted, but the worst consequences of the worldwide downturn were avoided in Australia, thanks principally to urgent financial stimulus by the government (as during the more recent pandemic). Nevertheless, many investors lost their jobs, resulting in significant reductions in family incomes.

The value of property dropped which meant that many highly geared investors were left in a position where their mortgages exceeded the value of their properties (in investment jargon, that’s described as being “underwater”). Some of their tenants failed to pay the rent and did not renew their tenancies. And lenders became understandably nervous about their customers’ capacity to make payments on their fixed interest rate loans.

ADF members in that position were fortunate because even though many of their partners lost their private sector jobs, our members retained their secure employment in the ADF which provided a regular income to partly service their loans. In many cases, this bought time to renegotiate with lenders, thereby staving off “fire sales” until the market lifted enough to consider rationalising their portfolio without extreme financial pain.

Three important lessons

The mental strain of these experiences was immense. People who went through them learned three important and timeless lessons (sadly, in the hard way) about borrowing money:

Lesson 1: Ask the “What if” questions

Before taking the plunge into debt of any kind, do a stress test by asking yourself the following questions:

• What if I or my partner were to lose our jobs or suffer a major drop in  income?
• What if I or my partner were to become ill and couldn’t continue to work?
• What if I or my partner were to die?
• What if we were to start a family?
• What if interest rates were to rise significantly?
• What if property values were to drop as a result of a recession?
• What if I were to discharge from the ADF?
• What if I can’t find a tenant or they stop paying their rent?
• What if my property suffers extensive uninsured damage due to the behaviour of tenants, floods, storms or other uninsured events?

Clearly, not all (or even, any) of these events will necessarily happen, but a sensible investor will always ask these questions of themselves before entering into a contract.

Lesson 2: Set financial goals and have a family budget

ADF members are used to exercising discipline, carefully planning the use of limited resources and assessing risk. We’re required to follow these sensible rules for obvious and good reasons. But when it comes to our personal lives, like so many Australians, it’s often a different story.

The point here is that by setting financial goals and carefully sticking to a budget to achieve them, you’ll be much better placed to realise and sustain your dreams of property ownership than a person who hopes that circumstances will haphazardly break their way.

You can learn more on our website about setting personal financial goals and creating a family budget.

Lesson 3: The importance of a “Nest Egg”

Consider setting aside a “nest egg” bank account of, say, 3 to 6 months in easily accessed funds to pay the bills in the event of that unexpected “rainy day”.

Sensible Borrowing

Our purpose here is not to dissuade you from borrowing money. On the contrary, borrowing to acquire growth assets like property, especially whilst an ADF member, can be a sensible decision. That’s because our members are (generally speaking) not only younger and fitter than the rest of the Australian community, they have considerable job security and receive a regular fortnightly income.

These characteristics make them highly desirable potential customers of motivated lenders. Therefore, when you decide to explore your borrowing options, don’t take the first offer that comes along. The property lending market is highly focused on attracting customers like ADF members, so do yourself a favour.

Benefit from the lessons learned the hard way by previous generations. Take your time, shop around for the best deal, ask the hard questions of lenders and of yourself, have clear goals and a sensible (even conservative) pathway or budget to achieve them. Do these simple things and your chances of success will increase and your levels of financial uncertainty and anxiety will be substantially reduced.

Postscript

If you feel that you might need a financial adviser to help in developing a sensible and achievable plan, you should read the information about financial advice on our website.

Make sure you also watch our short educational video Financial Advisers: The Facts and the Fiction. And consider consulting one of the licensed “fee only” financial advisers in the ADF Financial Advice Referral Program. In doing so, be aware that financial advice can be expensive, so make sure you discuss the scope and cost of advice before proceeding.

If ever you’re in severe financial difficulty, don’t ignore it. You should consider approaching a qualified financial counsellor who will provide you with free advice on strategies to improve your situation.